Davis Edwards Trading and Investing: Trading, Risk Management, and the Structure Deals in

the Energy Markets

Deregulacija energetskog tržišta!

Allowing anyone to trade electricity is a relatively new concept.
Prior to deregulation, only power plants owned by utilities could sell
power into a power grid. After deregulation, anyone could build a
power plant, produce power, and offer that power for sale. In deregulated markets, utilities
have shifted away from running power plants
to concentrating on operating transmission grids. There are power
plants now owned by power traders and operated by specialized service companies. These
changes revolutionized the power industry—
they created a market for electrical power (2010: 4).

Problemi sa tržištem električne energije

Generating electricity is one of the major purposes of the energy market. Electricity is used to
power a large variety of modern devices and
is so common that it is hard to imagine life without it. Unfortunately,
electricity can’t be stored and it’s very expensive to transmit over long
distances. Consequently, there is no national electricity market—it’s a
collection of small regional markets with unique characteristics and
regulations. In each of these markets, supply and demand must constantly be matched, which
results in a highly volatile spot market (2010: 6).

Opcije i njihova primena na energetska tržišta!

Options are an all-or-nothing type of instrument. It is possible to buy a million dollars
worth of options and lose the entire investment if the options expire worthless. Buying an
option contract is similar to buying insurance. Most often, the purchaser will pay a premium
and have the option expire worthless. Occasionally, the option will pay off big. Even though
the size of the downside is small (losing the premium) compared to the potential upside (a big
profit), the odds of making a profit are stacked against the option buyer. The option seller is
taking on a risk from the buyer, and needs to be compensated for taking that risk.

Two common applications for options are risk management and modeling energy
investments. In the energy market there are a lot of physical decisions that need to be made on
a daily basis. Do I turn the power plant on and convert my fuel into electricity? Do I lock in a
fuel supply for the winter now or should wait a little longer? Should I invest in building a new
power line between Oregon and Northern California? Option theory provides a way to quantify
those decisions.

From a transaction standpoint, option trading requires both a buyer and a seller. The
seller takes on the possibility of a big loss in exchange for money up front. The buyer pays a
premium to the seller for that service. If the option pays off, the seller will need to find the cash
to pay the buyer. With options, money is not magically created, it is simply transferred between
the two parties. The option buyer is described as being long the option or being long volatility
(since rare events will mean a big profit). The option seller is described as being short the
option or being short volatility (since rare events will mean a big loss) (2010: 20).

Options theory has simultaneously revolutionized the financial markets and caused a
huge number of financial collapses (2010: 21).

Spred opcije (str 23) – primena modela opcija na energetska tržišta!

Menadžment finansijskim rizikom

Modern financial risk management is usually a combination of two practices: mark-to-

market accounting and an analysis of earnings volatility. Typically, the risk of a portfolio is
synonymous with its earnings volatility—
often summarized by a measure called its value at risk or VAR.3 The VAR
is highly dependent on the choice of accounting methodology. While
risk management practices vary widely, almost all risk management is at
least partially based around a VAR methodology (2010: 35).

VAR (str. 35-38)

„Grci“ – potrebne informacije u menadžmentu rizikom (str. 38-39)

Upravljanje modelom rizika (str. 41)

 Šta je energetsko tržište!

The energy market is a type of commodity market that specializes in electricity,

heat, and fuel products. Difficulties in storing and transporting energy products
distinguish energy trading from other commodity markets. In most financial
markets, future prices are linked to current prices by the ability to buy a product
today and store it for future delivery. However, buying and holding is difficult
in the energy market. Many types of energy are impossible to store. In other
cases, a steady supply of new product is constantly reaching the market. As a
result, current prices and future prices are rarely linked. Instead, energy markets tend to
experience cyclical variations in prices (2010: 43).

Promptna i terminska tržišta

In the spot market, commodities are delivered on the day of the transaction. Spot
transactions are usually consumers purchasing small quantities of a commodity for immediate
use. The forward market is a financial market where delivery is scheduled at some agreed upon
point in the future (2010: 44).

Karakteristike trgovine na terminskom energetskom tržištu

Trades in the forward market are generally specified by several

factors:
• Underlying Instrument. The commodity being traded, usually
with a description of minimum quality standards that must be
met. Often, this is just called the underlying.
• Quantity. The amount of the commodity that must be delivered.
• Delivery Price. The price per unit due at delivery
• Delivery Date. The date at which the underlying instrument will
be delivered.
• Delivery Location. The location at which the underlying instrument will be delivered (2010:
47).
 From an economic perspective, allowing buyers and sellers to negotiate trades
ahead of time reduces the volatility of energy prices.
Energy is hard to store and transport. Giving large producers and
consumers the opportunity to line up trading partners ahead of time
reduces the uncertainty caused by short-term imbalances between
supply and demand (2010: 47).

Jedinstvene karakteristike energetskog tržišta:

1. Negativne cene

2. Ciklična tržišta

3. Nelikvidnost

4. Transparentnost cena

5. Direktne i spred trgovine

6. Baza

Kako funkcioniše hedžovanje u praksi (str. 63).

Definicija opcija (finansijski instrument koji se koristi u menadžmentu rizikom)

Option is a financial term that describes a common feature of many contracts. This
feature gives one person in the contract the ability to make
some kind of decision in the future, usually to buy or sell something at a
fixed price. Being able to place a dollar value on the ability to make future
decisions is a cornerstone of modern investing. Option contracts work
by having one person pay another for the right to take some action in
the future. The money paid by the buyer to the seller when the contract is signed is called the
premium (2010: 200-201).
 Two common applications for options are risk management and
modeling energy investments. In the energy market, there are a lot
of physical decisions that need to be made on a daily basis. Do I turn
my power plant on and convert my fuel into electricity? Do I lock in a
fuel supply for the winter now or should wait a little longer? Should
I invest in building a new power line between Oregon and Northern
California? Option theory provides a way to quantify those decisions (2010: 201).

Kako funkcioniše trgovina opcijama

The amount of money that needs to be transferred between the

buyer and seller is determined by the payoff of the option. Every option is assigned an
exercise or strike price. This is the fixed price at which trading can occur in the future.
For example, a call option involves the right to buy an asset at a fixed price. The owner
of a call option benefits when an asset price rises above the strike price. This allows the
owner to buy at a lower price than is otherwise available. The owner can also make an
immediate profit by reselling the asset at the current price (2010: 202).

A put option works similarly. It gives the owner of the option the
right to sell an asset at a fixed price. If the market price is greater than
the fixed price, a put option is worthless. No one will willingly sell at a
lower price than necessary. However, if the fixed price is higher than the
market price, the put buyer makes a profit by selling at a higher price (2010: 202).

Šta je nestabilnost cena

Volatility is the tendency of the market to see a large price move. Market volatility
goes in cycles—sometimes the financial markets are quiet and very little is going on, and
other times prices can change rapidly. Because of the way options pay out, option buyers
and sellers are very exposed to the market volatility cycle. For an option buyer, options
offer unlimited benefits if the prices move in one direction, and limited losses if the prices
move the other way.
 • An option buyer who is long volatility benefits when large price
movements become more likely.

• An option seller who is short volatility will benefit in a quiet market or if

prices stay exactly where they started. The premium is the only profit made by the option
writer. An option writer won’t make any more money if the option finishes very far out
of the money rather than just out of the money. However, the option writer has a great
deal to move if prices move in the wrong (2010: 206).

Funkcija opcija i njihova primena na energetskom tržištu

In some cases, options can be a good way to get into trades that
would otherwise be too risky. A good rule of thumb is that no single
decision should ever be so risky that it risks shutting down the trading
desk. If a trading desk is close to its risk limit, and strongly believes in
a trade, options can be a good way to take on more exposure without
taking on a large risk.

Another reason that options are important is their use in investing.

Many investment decisions can be modeled as financial options. For
example, building a power plant gives the operator the “option” of
burning fuel to produce electricity. The power plant operator will probably make the decision
to produce electricity whenever it is profitable. This is the same way that financial options
work. As a result, options provide a good way to analyze any investment that involves a
decision (2010: 206-207).

Primer korišćenja opcija u trgovini energentima (str. 214)

Kupovna (call) i prodajna (put) opcija

 Dva modela vrednovanja opcija

There are two steps to most option pricing models. The first is predicting statistical
distribution of likely movements in the underlying
price. The second step is determining how to replicate the option under those probability
conditions (2010: 221).

Binomijalno stablo (model na osnovu kojeg se predviđa kretanje cena u

budućnosti)

The simplest model of future prices is a binomial tree (Figure 3.5.1). A binomial tree
assumes that the underlying
prices can rise or fall a certain percent every day. That percent stays
constant over the life of the option. Prices start at today’s price and
slowly diverge from it over time (2010: 221).

Primer binomijalnog stabla (str. 222)

Predicting future prices is both subjective and inaccurate. Option

sellers need to have some assurance that they are being fairly compensated for the risk they are
taking on. This is done by calculating the
cost of eliminating the risk of writing the option contract (2010: 225).

Blek-Šolsova formula

The Black-Scholes formula is a closed form solution. That means

it has a unique answer that can be found by plugging in parameters
to the equation. The formula is a function of five variables: underlying
price, strike price, volatility, risk-free interest rate, and time to expiration. With these five
numbers, anyone could calculate the price of an
option. This opened up option trading to the general investor (2010: 228).
 Blek-Šolsova formula za izračunavanje kupovne i prodajne opcije (str. 230-231)

Grci (str. 232-233)

Šta je rizik!

Risk, as a term used in general speech, means a potential for danger.

In the financial markets, more specific terms need to be used. Market
risk refers to the likely size of a profit or loss (P&L) that will occur with
a specific probability in some time frame. For example, a trading firm
might define risk as the threshold that daily P&L exceeds once a month on average (str. 345-
346).

Svrha VAR-a (Value at Risk)

The purpose of VAR is to give a simple description of risk. For example, a VAR report
might be: “Once a month the trading desk can
be expected to make or lose at least $1 million over a one day period.”
This description is both meaningful and short enough to be conveyed
to a large audience. As a single number, it is simple enough to use in
daily reports and easy to examine for trends. For example, if the VAR
estimate had fallen from $20 million to $1 million in the past week, this
would represent a significant decline in the risk (and probably size) of
the portfolio (str. 347).

Delovi u opisu VAR-a! (str. 347)

Kako se izračunava VAR!

There are three main steps to calculating a VAR number, which are depicted in
Figure 6.1.1.
 1. Construct a distribution of possible P&L moves (usually by examining what
types of moves have happened in the past).

2. Turn all the moves into positive numbers, and sort the P&L into a

new distribution.

3. Find the value in the nth percentile of the distribution (the 95th

and 99th percentiles are popular choices for VAR) (str. 347)

Nedostatak VAR-a (str. 351)

Because VAR is a single number, it has some limitations: it abstracts

away the fundamental behavior of a portfolio. Typically, P&L is not
normally distributed—there isn’t an equal chance of making and losing money. Many energy
assets—particularly those that can be modeled by options—have asymmetrical payoffs.
For example, a peaking power plant is going to lay idle for most of
the year—it will lose money regularly whenever it is inactive. In all but
the summer months, small operational charges will accumulate daily.
A couple times a year—usually hot summer afternoons—the power
plant will have the opportunity to make large windfall profits as it
is pressed into duty, as shown in Figure 6.1.4. This is an example of a
portfolio that is “long volatility”—a portfolio that benefits from large
P&L movements and increasing volatility.

Rizik modela (kada model koji se koristi za procenu rizika ne funkcioniše)

Energy traders commonly encounter model risk—the risk that either

the methodology or assumptions used to value assets becomes invalid.
Poor assumptions and incorrectly designed models cause risk management problems in every
financial market. However, the complexity
of energy models and their extended lifetimes make these problems
especially prominent in the energy markets (str. 357).
 Zbog čega dolazi do nefunkcionisanja modela

Models and the viability of the model’s assumptions change over time. If a model lasts
20 years, a lot of things can change. Investments like power plants, pipelines, and natural gas
wells all have an extremely long life span. Even when a pricing model is sufficient at first,
there is no guarantee that things won’t change. Assumptions made years earlier can be
invalidated by regulatory changes, population shifts, and technological changes. Exacerbating
this problem is the problem of employee turnover—commonly, the original developers of the
models have moved to another job or retired before problems develop (str. 358).

Greške u proceni parametara

Still another modeling problem concerns the estimation of parameters.

For example, a spread option will depend on an estimate of the correlation between two assets.
In these cases, the correlation can’t be readily determined from an independent source.
Historical spot prices will underestimate forward volatility. Forward prices overestimate
correlation. As a result, it is fairly common for a couple of model parameters
to be chosen (fairly arbitrarily) when a model is created. If any of those
parameters turn out to be a poorly chosen, the model might change
dramatically (str. 359).

Koraci u redukovanju rizika modela (str. 359-360)